Barry Eichengreen's Theya Culpa
By Arnold Kling
Everywhere I go, I see links to this article by Barry Eichengreen. I was expecting to find something good. Instead, it is a classic Theya Culpa, a one-sided exercise in finger-pointing, which educates no one, least of all the people who agree with it and fervently recommend it. Some excerpts follow.
the problem lay not so much with the poverty of the underlying theory as with selective reading of it–a selective reading shaped by the social milieu. That social milieu encouraged financial decision makers to cherry-pick the theories that supported excessive risk taking. It discouraged whistle-blowing, not just by risk-management officers in large financial institutions, but also by the economists whose scholarship provided intellectual justification for the financial institutions’ decisions. The consequence was that scholarship that warned of potential disaster was ignored.
I would like to see the scholarship that warned that mortgage securitization was a problem. I would like to see the scholarship that foresaw the problems with risk-based capital rules and market-value accounting. I would like to see the scholarship that saw the entire financial system as vulnerable to a decline in house prices.
where were the intellectual agenda setters when the crisis was building? Why did they fail to see this train wreck coming? More than that, why did they consort actively with the financial sector in setting the stage for the collapse?
Oh, yes. It was all a plot by the financial sector to set the stage for the collapse, with the aid of “intellectual agenda-setters” . I’m sorry, but I cannot equate this sort of conspiracy mongering with analysis.
Meanwhile, deregulation was on the march. Memories of the 1930s disaster that had prompted the adoption of restrictions like the Glass-Steagall Act, which separated commercial and investment banking, faded with the passage of time. This tilted the political balance toward those who, for ideological reasons, favored permissive regulation. Meanwhile, financial institutions, in principle prohibited from pursuing certain lines of business, found ways around those restrictions, encouraging the view that strict regulation was futile. With the elimination of regulatory ceilings on the interest rates that could be paid to depositors, commercial banks had to compete for funding by offering higher rates, which in turn pressured them to adopt riskier lending and investment policies in order to pay the bill. With the entry of low-cost brokerages and the elimination of fixed commissions on stock trades, broker-dealers like Bear Stearns, which had previously earned a comfy living off of such commissions, now felt compelled to enter riskier lines of business.
I have yet to hear one coherent explanation of how the relaxation of Glass-Steagall caused this crisis. At least the proponents of the view that it was all the Community Reinvestment Act (a view which I do not endorse) have a story to tell.
The other two elements in the “deregulation is on the march” paragraph are the end of deposit-interest ceilings and the elimination of fixed commissions on stock trades. Is there any economist out there who believes that deposit-interest ceilings were sustainable or that fixed brokerage commissions were economically justified? Is there an economist out there who buys the story that the way to restrain financial firms from innovating or risk-taking is to ensure that they obtain regulatory rents?
the twenty-first century will be the age of inductive economics, when empiricists hold sway and advice is grounded in concrete observation of markets and their inhabitants.
This may be true. It may be a good thing. I would be the last person to defend the mathematical theorists. But I also think it is quite a stretch to try to pin much responsibility for the financial crisis on the theorists.
There are problems with the direction that mainstream economics has taken over the past thirty years (or more). But if the new way forward is represented by Eichengreen’s McCarthy-esque conspiracy tales, I am afraid that things will get worse rather than better.